Thursday, August 19, 2010

Macro Aggregation Fallacies

It would be very convenient if the macro economy could be steered like a big oil tanker using a few inputs. Sure, it's hard to steer an oil tanker, but it's feasible. You just need an objective (full employment!), inputs (a map and a clear view), and control variables (the rudder, engine speed). After all, Newton took all those epicycles, and merged them into simple F=G*m1mm2/r2, so that's what scientists do. I agree it's nice when it happens, but sometimes it's not possible, and it's obviously not true that historians know nothing merely because they don't know math or statistics.

Paul Krugman notes that there's a simple relation between the 'private sector surplus' and the interest rate. He uses graph above to show that the higher the interest rate, the more the private sector--consumers plus the businesses they own--will save.

Fine enough, that's all partial equilibrium analysis. That is, the capital goes outside this system, and the price of riskless capital (interest rate) is set exogenously. Supposedly:

in normal times the central bank can reduce interest rates enough to set this surplus at zero, or no larger than the public sector deficit, thus ensuring full employment

In stressed times after a bubble (eg, the 'after' line above), the private sector tries to run a big surplus as it pays down debt. This causes recessions, which can be mitigated if not eliminated via countercyclical budget deficits by the public sector.

This argument would be tenable if it were 1936 and people never tried it, but it has been tried over and over and if a government could spend itself to prosperity and stability, a couple such countries would demonstrate this. Instead, we have the examples of the contrary, where fiscal restraint and modest automatic stabilizers were consistent with the wealthier countries post WW-II.

But what I love is the way Krugman totally ignores the heterogeneity of investment and employment, and simply thinks that people and companies are saving 'too much', and so anti-savings by the government would offset this, leading to full-employment bliss. That kind of thinking is profoundly misleading.

5 comments:

dmfdmf
said...

> That kind of thinking [by Krugman] is profoundly misleading.

I would say it is *intentionally* misleading, i.e. dishonest, coming from Krugman who is smart enough to know it. Also, there is the inherent injustice and dishonesty in Keynesians because the govt spending they advocate is taken by force (taxes) or created out of thin air (inflation). No amount of math can rationalize away this problem, though they continue to try.

When people increase savings, interest rates should fall, increasing investment spending. If interest rates are near zero, how can they fall further to increase investment spending? It is in this way that people are saving too much, because there isn't a counterbalancing increase in investment. Someone has to spend (either consumers or businesses) or the economy stops.

This is grade school Keynesianism. As you say, it requires the assumption of a closed system. At least $8T in wealth has been wiped out. Consumption must fall. Investment to expand capacity will not happen with falling consumption. The answer is investment for export, import substitution, cost reduction and NEEDED infrastructure.

The government can help by creating a climate favorable for investment. Instead we see govt policies aimed at delaying needed adjustments. Three examples. Home ownership is too high. A tax credit for first time home buyers is counter productive. A tax credit for people who will buy foreclosed houses and rent them out is helpful. Example 2: We know that government services have an income elasticity >1. Since much of our wealth has turned out to be illusory, it is necessary to cut govt services. But the "stimulus" plan encourages the opposite. Example 3. Government stimulated spending in green energy and high speed rail boondoggles does nothing but impose additional burdens on the private sector - hurdles standing in the way of wealth creating investment.

EVERY policy initiative of the Obama administration delays economic recovery.